The Mathematics of Catastrophe

Written by Doug Dahmer  |  January 29, 2015

I was not the best math student in the world but I certainly enjoyed numbers. I especially liked prime numbers and their unique indivisibility. I still cannot figure out how they come to be.

In the course of my retirement income planning career, I had another math lesson that now holds my interest even more. Here is the lesson. If you halve a number, you have to double the new number to get back to the original number.

Here is the lesson. If you halve a number, you have to double the new number to get back to the original number.

Now put your income generating capital into that equation and you will see why it holds my interest. If you are deriving income from X and it goes to 1/2 X… well, you don’t have to be Einstein to see the problem.

When you draw a predetermined dollar amount from your investment portfolio and it drops by ½ you are about to experience the mathematics of catastrophe. Everything you planned is about to come unwound and it will happen quickly. Run a little test with any numbers you want and you will see how trouble escalates.

The S&P 500 is a very broad market index and serves as a useful proxy for this issue. Take the last 20 years. Between 1995 and 2000 the S&P doubled. Between 2000 and 2003 it dropped by ½. Between 2003 and 2008 it doubled. By 2009 it dropped by ½ again and took four years to double from that low.

Some part of your retirement income is probably made up from investment capital. These frequent periods of market declines were your friend when you were accumulating assets, now they are your worst enemy.

Pension style asset management that avoids big mistakes, establishes appropriate allocations and sets aside reserves to meet income needs is the best way to weather the world of volatility in retirement.

The S&P is up nearly 100% during its last big run. Is your investment portfolio ready to deliver what you need if things cool down?

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